Adviser fees - devolution or evolution
My last article on Fees and Commissions elicited a surge in readership and due to some strange quirk of search engine optimization (SEO) , the article was very briefly (thanks to Google), the most popular article in the world with respect to individual financial adviser compensation.
Perhaps because of these high search engine rankings, I was contacted by famed investor advocate - Ken Kivenko and I mentioned to him that I would likely author a follow-up article on fee-based adviser compensation with more detail.
But first a recap.
Financial Advisers - like stock brokers and mutual fund brokers, traditionally have used a transactional or commission based model. If you buy a stock or mutual fund, you pay some sort of commission. If you sold a stock, you likely paid some sort of commission to sell as well.
In recent years, mutual funds are bought and sold quite differently than they used to be. Some decades ago, mutual fund commissions were fixed and non-negotiable. In the mutual fund world there can be a commission to buy or sell but unlike stock transactions you do not pay both.
[Editor's note: please refer to my Fees and Commissions article for the differences between front-end and back-end loads.]
A solution looking for a problem
The Canadian Securities Administration torched off a storm of controversy with its recent discussion paper on mutual fund fees and commissions - ostensibly to identify potential investor protection issues arising from the current structure of mutual fund fees.
Our national business papers has further fueled the controversy by opining that the transactional ( commission based) model was rife with conflict of interest issues and generally, commissions of any sort were/are evil incarnate and must be banished permanently.
I do not agree with this view.
I should firstly point out that the introduction of service fees (trailing commissions) in the 1980's had pretty much eliminated the threat of account churning of mutual funds and eliminating many of the conflict of interest scenarios.
[Churning - the frequent purchasing and selling of securities for the purpose of earning additional commissions.]
Secondly, most advisers have voluntarily eliminated front-end loads on mutual funds, likely in response to the Canadian banks domination in the fund industry and their introduction of "no-load" funds.
A majority of advisers in the last decade or so have decided that earning a total service fee/commission of about 1% a year is likely to be a fair and equitable compensation for managing large amounts of money. Advisers have gradually eliminated their front-end loads and nowadays typically charge a 0% commission for the purchase of a mutual fund. Due to the nature of a front-end mutual fund purchase there is never any commissions to sell a front-end mutual fund. Therefore, a client buys the mutual fund for 0% commission and can decide to sell this fund at any time without incurring a commission - zero in, zero out.
The trend towards 0% commissions has had some interesting and unanticipated effects. The back-end option of buying a mutual fund was introduced in the 1980's to help clients avoid paying front-end commissions. In a back-end load option you could avoid paying a commission to buy and a fee to sell. There was one condition though. In order to avoid all of these commissions or exit fees you had to promise to leave your money at the fund company for a full seven years. If you sell within that time you may have to pay a significant exit fee.
Despite the possibility of an early exit fee, this was a good deal for the client as the back-end option could now easily avoid the lofty front-end commissions of the time.
A reader by now may have gathered the crux of the problem for advisers. Advisers have eliminated the front-end load on mutual fund purchases so that clients do not have to pay commissions to buy or sell a mutual fund. If this is the case, why buy a back-end mutual fund?
A no-brainer. You want the mutual fund with a front-end set at 0% commission - the one without conditions attached to it. To no one’s surprise, back-end load fund purchases are declining in popularity.
Commissions are disappearing or have disappeared which means it is far cheaper to buy a mutual fund today than it was 25 years ago. However, an interesting question arises. Why have commission based advisers cut their own commissions?
The answer is straightforward. Advisers are quite happy to receive just the 1% annual trailing commission paid to them from the fund company.
The 1% commission (sometimes referred to as a service fee or trailing commission) is a type of asset based fee. The interest of the adviser and the client is now aligned. If the value of the client's account goes up, then the adviser receives higher compensation. If the client’s account value goes down – the adviser also feels the pain. Since there are no buy or sell commissions to worry about1, the problem of account churning has essentially, been eliminated because the adviser is receiving a regular stream of asset based compensation and no longer is tempted to churn the account in order to generate commissions.
1Front-end load mutual fund purchase set by the adviser to be 0% commission. The mutual fund prospectus allows up to about a maximum 4% front-end load to be charged, but in this case, the adviser sets it at 0%. The 1% trailing commission/service fees are in reference to the “trailer” received from equity mutual funds (stock-based mutual funds).
You might come to the conclusion - hey that's a great deal! I don’t have to pay commissions anymore because my adviser has waived them and my adviser is still being paid an open, transparent and disclosed fee to manage my investments. What's wrong with that?
Indeed, what is wrong with that. But alas, in the world of securities regulations, life is not so simple.
The regulator has pointed out that the asset based trailing commission of 1% could represent a potential conflict of interest.
Well, how about those possible conflict of interest scenarios? Would the 1% trailing commission be considered as an inducement to buy that fund company's products?
Let's think about that for a nanosecond. Nope. All adviser based mutual fund companies pay about the same trailing commissions of 1% so if they all pay the same then how could it possibly be seen as an inducement?
So yes, we advisers are having a rough time of it. We have voluntarily reduced or eliminated commissions for mutual fund purchases and now it appears that the 1% asset based trailing commission that many advisers derive most of their income - is now under the intense scrutiny of the regulators and the popular press (gleefully sharpening their knives - intent on eliminating all commissions of any description).
Oddly, the solution is obvious but in my view, unnecessary.
We could end the controversy merely by eliminating the word "trailing commission" and call it something else - perhaps a AUM fee (asset under management fee). The word "commission" is now eliminated -problem solved! Everyone declares victory and goes home. The economy gets a boost as legions of lawyers get to rewrite the securities regulations. Certainly, a win-win situation for everyone.
Heaven help us, there is another but. The press points out that the new proposed AUM fee of 1% is being paid by the fund company. You can't have the fund company pay the adviser because that is a conflict of interest.
What to do now?
How are we going to make the perennially unhappy popular press happy?
Some years back I suggested that the AUM model would become more prevalent. It looks like it might happen sooner than expected.
Here is the solution. The fund company could strip out the adviser compensation in the mutual fund and then we can force the adviser to charge it to the client! We'll call this new adviser compensation model a fee-based model.
If the client pays the adviser directly there will be no conflict of interest because the client is handed a bill and has to pay it. Bills are open, transparent and being what they are, bills are generally disclosed to the clients too. Brilliant!
What is the net economic benefit to the client of the two adviser compensation models?
Here they are again:
1. adviser compensation of 1% asset based commission paid by the mutual fund company , zero commissions to client.
or
2. adviser compensation of 1% asset based fee paid by the client, zero commissions to the client.
From an adviser viewpoint, which one is better?
This is a tough one. In Option 1, I get 1%. In Option 2 I get 1%. Help, my brain hurts! It seems to me that both are the same. Is this a trick question?
From a client’s viewpoint which one is better? Option 1 or Option 2?
Let’s ask a client.
Wait a second! You mean that in Option 2, I have to pay a bill?
Yessir..that is correct!
But I am not paying a bill right now.
You are not paying the bill right now because the price of advice is built into the product. We reduce the price of the product and hand you a bill for the difference in product prices. Isn't that great!
But I kinda like the old all-in-one pricing. I already know that my adviser is earning a commission for the services he provides...
Shush! Sorry, we are not allowed to use the "C" word any more. Commissions are out...fees are in. Option 2 means you have to pay a fee out of your pocket but the fees might under certain circumstances be tax deductible. I am not supposed to tell you that by the way. I am not a tax professional. Who knows…in the future…with the budget cut backs, the fees may not be tax deductible after all.
I am confused. It sounds like I will be paying 1% one way or another. Why bother changing anything?
Exactly! And I am more confused than you. However keep this quiet. We're changing words and calling commissions something else. We are now calling them fees. It will make the press deliriously happy. Regulators can claim they are looking after consumers interests. Lawyers will make billions!
--
My apologies for my light hearted Walter Mitty moment…just couldn’t resist.
Back to the serious stuff.
The raging controversy rages on internally in our industry but for almost all Canadians the differences between a transactional versus a fee based account is hardly worth discussing at the next cocktail party.
My view is that a zero commission based front-end mutual fund purchase is very close to a fee-based account without all of the complications.
Although the press delights in skewering the traditional commission based model, the asset based model is nowhere near a panacea it is painted to be. The U.S. industry has used fee-based adviser compensation for a much longer time than in Canada and there has been a number of problems, issues and yes, even lawsuits from clients suing their advisers regarding fee-based accounts.
Here are some cons about the new proposed fee-based accounts to think about:
1. Adviser fees may be higher than the old commission structure. For instance, fixed income funds (bond funds) have generally lower compensation than equity (stock -based) mutual funds. Advisers will be forced to charge 1% fee where previously the commission was only a half percent (0.5%). I have to ask the following question to the press about their anti-commission campaign; why is a high fee always better than a low commission?
2. Why put clients in stock mutual funds that can drop up to 60% in value (Does anyone remember the S&P dropping almost 60% in 2009? An adviser could put all of the client's money into a money market fund and collect his 1% per year and not have to worry about the stock market. The adviser makes the same amount of money, say 1% whether the account is ultraconservative or not. So why take chances? Fee-based accounts as a result, may be dumbed down to help preserve the adviser's steady stream of fee-based income. Hmm..sounds like a conflict of interest to me. Weren't fee based accounts supposed to eliminate conflicts of interest?
3. Since fee-based accounts are based on assets under management, would an adviser encourage a client to make a very substantial charitable donation, or make a large real-estate purchase? Advisers will be continually worried about losing assets from fee based accounts and make recommendations that may not be to the client’s benefit.
4. In a fee-based account, the adviser's firm generally puts limits on the number of transactions (in order to save costs) that can be done in this type of account. That can be good or bad however there are some lawsuits in the U.S. concerning the charging of fees with no activity in the account. Will advisers be sued if they recommend doing nothing if nothing is the best thing to do? How about his scenario? The adviser just doesn't bother to do any work on the existing accounts and his or her business model is to collect new clients and new assets only. That 1% per year is coming in every year whether the adviser works for it or not.
5. High Net Worth clients (HNW). Rich people are funny. Thankfully, I am not one of them. Their concept of percent of assets is often different than the ordinary joe. HNW clients tend to think of gross dollars spent rather than in percentage terms. Will a HNW client pay a 1% annual fee on a sizeable account? Perhaps not. They may be willing to pay perhaps as little as 1/10th of that. Brokerage firms and Dealers may face increasing price pressures vying for the same HNW client.
6. If fee-based revenues become increasingly tight, firms will have to compensate and charge fees on products where there are none currently - like GICs or high yield savings accounts. Undoubtedly, there could be pressures to charge management fees on all assets or perhaps even charge fees for holding cash when the stock market takes an occasional scary dive.
7. The little guy. How are you going to charge asset based fees on a $100 a month investment plan? The small or new investor will not be able to afford it because fee-based account minimums are quite high, usually starting at $100,000 or so. If we make mutual funds unaffordable, these clients will go elsewhere for cheaper alternatives.
So where do we go from here? Despite the question marks I’ve raised, it looks like the fee-based compensation model will be given the nod. Commissions will be eliminated and be replaced with fees. The fee-based account does appear to have an economic benefit for high net worth investors who have the bargaining power to reduce their fees. For the rest of us, I think the current system is fine. We have mutual fund compensation structures for small and large investors alike and fee-based accounts are nothing new as we already have had this option for several years.
Hopefully, this article has shown some of the cons of fee-based accounts but I am of the view that more choice is better. I am all for reform but eliminating all of the traditional commission structures may not be of benefit to everyone.
